Note that the figures for Windows and Office are boosted by deferred revenue from upgrade offers. The PC sales decline will be reflected in Windows client sales next time round.

CFO Peter Klein spoke of hoped-for improvements in Windows 8 device fortunes based on refinements coming in Windows “Blue” as well as more power-efficient CPUs coming from Intel. “We are confident we are moving in the right direction,” he said.

He also discussed the new subscription-based model for Office. Office 365 has added five times more subscribers this quarter than in the same period last year, he said, and revenue exceeds $1 billion.

Suh said that System Center revenue is up 22% and that Hyper-V has gained 4 points of market share in the year. Lync and SharePoint are also growing.

In answer to a question about Surface, Microsoft’s own-brand tablet, Klein spoke about a coming “broader array of Windows 8 devices including lower price points.”

The deferred revenues disguise what would otherwise be a decline in Windows sales, but in other respects these figures are remarkable, particularly in a difficult economy.

Isn’t Windows 8 a failure, and won’t declining PC sales take Microsoft down too? It is possible, but so far the company has proved resilient. Perhaps the most significant positive here is that both Office 365 and Azure are working for the company, which means that cloud computing is not killing Microsoft’s business in the way that some speculated.

Last week Amazon CEO Jeff Bezos spoke at a “Fireside Chat” with AWS (Amazon Web Services) chief Werner Vogels. It was an excellent and inspirational performance from Bezos.

If there was a common theme, it was his belief in the merit of low margins, which of necessity keep a business efficient. Low margins are also disruptive to other businesses with high margins. But how low can margins go? In some cases, almost to nothing. Talking of Kindle Fire, Bezos remarked that “We don’t get paid when you buy the device. We get paid when you use the device.” It is the same pay as you go model as Amazon Web Services, he said, trying to remain vaguely on topic since this was an AWS event.

His point is that Amazon makes money when you buy goods or services via the device, not from profit on the device itself. He adds that this makes him comfortable, since at that point the device is also proving its value to the customer.

Google has the same business model with its Nexus range, which is why Google Nexus 7 and Amazon Kindle Fire are currently the best value 7” tablets out there. For Google, there is another spin on this: it makes the OS freely available to OEMs so that they also push Google’s adware OS out to the market. If you are not making much profit on the hardware, it makes no difference whether you or someone else sells it.

We do not have to believe that either Amazon or Google really makes nothing at all on the Kindle Fire or Nexus 7. Perhaps they make a slim margin. The point though: this is not primarily a profit centre.

This is disruptive because other vendors such as Apple, Microsoft, Nokia or RIM are trying to make money on hardware. So too are the Android OEMs, who have to be exceptionally smart and agile to avoid simply pushing out hardware at thin margins from which Google makes all the real money.

Google can lose too, when vendors like Amazon take Android and strip out the Google sales channels leaving only their own. This is difficult to pull off if you are not Amazon though, since it relies on having a viable alternative ecosystem in place.

But where does this leave Apple and Microsoft? Apple has its own services to sell, but it is primarily a high margin hardware company selling on quality of design and service. Apple is under pressure now; but Microsoft is hardest hit, since its OEMs have to pay the Windows tax and then sell hardware into the market alongside Android.

Ah, but Android is not a full OS like Windows or OSX. Maybe not … yet … but do not be deceived. Three things will blur this distinction to nothing:

1. The tablet OS category (including iOS) will become more powerful and the capability of apps will increase

2. An increasing proportion of your work will be done online and web applications are also fast improving

3. More people will question whether they need a “full OS” with all that implies in terms of maintenance hassles

Microsoft at least has seen this coming. It is embracing services, from Office 365 to Xbox Music, and selling its own tablet OS and tablet hardware. That is an uphill struggle though, as the mixed reaction to Windows 8 and Surface demonstrates.

Most of the above, I hasten to add, is not from Bezos but is my own comment. Watch the fireside chat yourself below.

Today’s news that Microsoft is writing off $6.2 billion from the useless acquisition of aQuantive in August 2007 gives me pause for thought.

How bad is this company at acquisitions? Particularly those under CEO Steve Ballmer’s watch. He became CEO in January 2000.

Microsoft acquired Danger in February 2008 for $500M. Small relative to the aQuantive acquisition, but how much further money did the company burn transforming Danger from an excellent cloud and mobile company to the group that came up with Kin, the phone withdrawn from the market after just two months on sale? Not to mention the downtime and threatened loss of data suffered by Danger’s online service under Microsoft’s stewardship.

Microsoft attempted to buy Yahoo for $44.6bn in 2008. Yahoo’s executives declined, a move that was (very) bad for Yahoo shareholders but quite possibly right in a business sense; it would not have been a good fit.

Microsoft acquired Groove Networks complete with Notes inventor Ray Ozzie in March 2005. I put this in the disaster category. Groove went nowhere at Microsoft. Ozzie became Chief Software Architect and talked of internet vision but did not deliver. The wretched SharePoint Workspace is apparently based on Groove.

What about the good ones? My view is that Microsoft paid too much for Skype at $8.5 billion but at least it acquired a large number of users and has some chance of enhancing its mobile offerings with Skype integration.

Microsoft acquired Bungie in 2000 and given the success of Halo (without which, maybe, the whole Xbox project might have faltered) we have to count that a success, even though Bungie was spun off back to independence in 2007.

Other notables include Great Plains in December 2000 (now morphed into Dynamics ERP); Connectix in February 2003 which got Microsoft started in virtualization; and Opalis in December 2009 whose software now plays a key role in Microsoft’s System Center 2012 private cloud software.

Winternals in July 2006 was a great acquisition. Microsoft acquired some indispensable Windows troubleshooting tools, and also Mark Russinovich and Bryce Cogwell, able people who I suspect contributed to the transformation of Windows Vista into Windows 7, and in the case of Russinovich, to the technology in Windows Azure which now seems reborn as an excellent cloud platform.

If we are really in the post-PC era, then one of two things will happen. Either Microsoft will make a big success of non-PC products, or it will start delivering shocking financial results. Neither is yet true. Here are the results just announced, broken down into a simple table.

A few observations. Server revenue (though not profit) exceeded client revenue; I am not sure if this is the first time it has done so, but it is unusual. The Office division enjoyed a remarkable quarter, and the press release mentions 10% growth in Exchange and SharePoint, and 30% growth (from a smaller base) in Lync and Dynamics CRM. Azure? Not mentioned so I presume revenue is small.

Where is Office 365? Somewhere in the Office figures I would guess; and once again, since it is not mentioned, I think we can assume it is not delivering a large amount of revenue yet. I would like to know more though.

What Microsoft calls Online is formed of Bing search and services and advertising income. Another hefty loss, but revenue is up, loss somewhat reduced, and Microsoft claims that “Bing-powered US market share, including Yahoo! properties, was approximately 27%”. Not bad.

This is the big quarter for gaming and Xbox delivered accordingly. The faltering Windows Mobile and Windows Phone 7 are somewhere lost in those Xbox numbers, and again its revenue is not mentioned in the press release.

Microsoft CEO Steve Ballmer gave the keynote at CES in Las Vegas last night. It was a polished performance and everything worked, but was short on vision or any immediate answer to the twin forces of Apple iPad and Google Android which are squeezing out Microsoft in the mobile world – smartphones and tablets – which currently forms the centre of attention in personal computing.

That said, CES stands for Consumer Electronics Show; and Ballmer did a good job showing off how well Kinect is performing, claiming sales of 8 million already. He showed more examples of controlling Xbox through speech and gesture, and said that Kinect is also boosting sales of the console; clearly it is now taking it beyond the hardcore market of first-person shooters.

We saw some fun new Windows devices, such as Acer’s dual-screen Iconia laptop.

There was also a demonstration of the updated Microsoft Surface which now runs full Windows 7 and does not require hidden cameras, so that it can now be used in more scenarios, such as for interactive digital signage.

All well and good; but what about mobile? We got a Windows Phone 7 demo, but no sales figures, nor any mobile partners on stage; I’m guessing they are too busy promoting their new Android devices. Ballmer did say that the phone is coming on Verizon and Sprint in the first half of this year. Application availability is improving, but how will Microsoft win attention for its smartphone? My local high street is full of mobile phone shops, none of which even stock it as far as I can tell. There is a tie-in with Xbox Live which may help a little.

The problem though is that Microsoft does not seem to be wholeheartedly behind the Windows Phone 7 OS, which is based on Windows CE with a new GUI and Silverlight/XNA runtime for applications. Rather, Microsoft is signalling that full Windows is its future mobile operating system. At CES it announced Windows on ARM, the processor of choice in mobile, and during the keynote we saw the next version of Windows (though with the Windows 7 GUI) running on various ARM devices.

The power available in new System on a Chip packages like NVIDIA’s Tegra 2 leaves me in no doubt that full Windows could technically run on almost any size of device; but that does not make it the sensible choice for all form factors. Note also that while it was not mentioned at CES, NVIDIA has said that Tegra 2 is optimized for Android.

Microsoft could plausibly have released a tablet based on the Windows Phone 7 OS, which is built for touch control, this year. Instead, it will be at least 2012 before we see a Windows 8 tablet, and we are taking it on trust that this will really work nicely with touch and not need a stylus dangling at the side. By then Apple will, I presume, be releasing iPad generation 3.

Putting this in a developer context, what is Microsoft’s mobile development platform? Silverlight and XNA? The full Windows native API? Or HTML 5? Each of these is very different and it seems to me a muddled story.

The moment of magic comes when someone walks through the gaming area and Xbox flashes up the message that they have signed in. No button was pressed; this was face recognition working in the background during gameplay.

So Kinect is amazing. And it is amazing: it is controller-less video gaming that works well enough to have a lot of fun. That said, I also have reservations about the device, though these are first impressions only, and feel it is let down in a big way by the games currently available.

My device arrived on the UK launch day, November 10th. It is a relatively compact affair, around 28 cm wide on a stubby stand. The first task is positioning it, which can be a challenge. You are meant to place it above or below your TV screen, at a height of between 0.6m to 1.8m. I was lucky, in that our TV is on a stand that has space for it; the height is fractionally below 0.6m but it seems to be happy. Alternatively, you can purchase a free-standing support or a bracket that clips to the top of a TV. I imagine there are some frustrated first-day purchasers who received a device but cannot satisfactorily position it.

You also need free space in front of the set. Our coffee table got moved when the Nintendo Wii arrived, so the 6ft required for one-player play is not a problem. Two-player is more difficult; we can do it but it means moving furniture, which is a nuisance. Overall it is more intrusive than the Wii, but less than Rock Band or Guitar Hero with the drum kit, so not a deal-breaker.

Microsoft takes full advantage of over-the-wire updates with Kinect. After connecting, the Xbox, the device firmware, and the bundled Kinect Adventures game all received patches; but the procedure went smoothly.

Kinect is a sophisticated device, a lot more than just a camera. There are three major subsystems in Kinect: optical, audio and motor.

Motor is the simplest – the stubby stand also contains a motor assembly that swivels the device up and down, enabling it to allow for different positions and to find the optimal angle for players of different heights.

The optical subsystem includes two cameras and an infra-red projector. The projector overlays a pattern on the field of view. This allows the first camera, a depth sensor, to map the position of the players in three dimensions. This lets the system detect hand movements, for example, which are usually closer to the camera than the rest of the body. The second camera is a colour device more like the one in your webcam, and enables Kinect to take pictures of your gaming antics which you can share with the world if you feel so inclined, as well as presumably feeding into the positioning system.

The audio subsystem includes no less than four microphones. The reason is that Kinect does voice recognition at a distance, so needs to be able to compensate for both the sounds of the video game and other background noise. Using multiple microphones enables the audio processor to calculate the position of sounds, since each microphone will receive a sound at a fractionally different time.

These sensors systems are backed by considerable processing power – necessary because the Xbox itself devotes most of its processing to the game being played. The trade-off in systems like this is that the more processing means more accurate interpretation of voice and gestures, but taking too much time introduces lag. As I saw at the NVIDIA GPU conference in September – see here and here for posts – very rapid processing enables magic like robotic pinhole surgery on a beating heart – and like Kinect, that magic is based on real-time interpretation of physical movement. Kinect is not at that level, but has audio and image processor chips and 512MB RAM, along with other components including for some reason an accelerometer, mounted on three circuit boards squashed into the slim plastic container. See for yourself in the ifixit teardown.

But how is it in practice? It certainly works, and we had a good and energetic time playing Kinect Adventures and a little bit of Joy Ride. Playing without a controller is a liberating experience. That said, there were some annoyances:

Kinect play is more vulnerable to interference than controller gaming. If someone walks across the play area, for example, it will interfere.

In the Kinect system, there is no such thing as a click. Therefore, to activate an option you have to hover over it for a short period while a progress circle fills; when the circle is filled, the system decides that you have “clicked”. It is slower and less reliable than clicking a button.

The audio system enables voice control which seems to work well when available, but most of the time it seems not to be available. Considering the amount of hardware dedicated to this, it seems rather a waste; but presumably more is to come. Controlling Sky player by voice, for example, would be great; no more hunting for the remote.

The Kinect seems to work best when you are standing. For something like a driving game, that is not what you want. Apparently seated gameplay is supported, but does not work properly with the launch games; so watch this space.

Launching stuff before it is really ready seems to be ingrained in Microsoft’s culture. Is Kinect another example? To some extent I suspect it is. I recall the early days with the Nintendo Wii as exciting moments of discovery: the system worked well from the get-go, and the bundled Wii Sports game is a masterpiece. The Kinect games so far are less impressive.

In fact, my overwhelming impression so far is that this is great hardware waiting for software to show what it can do. The 20,000 Leaks mini-game in Adventures is not very good – you are in a glass cage underwater and have to cover leaks to stem them – but it is interesting because you have to use head, hands and feet to play it. It could not be duplicated with a conventional controller, because a conventional controller does not allow you to move one thing this way, and another thing that way, at the same time.

It follows that Kinect should enable some brilliant new gaming concepts. I’d love to see a stealth adventure done for Kinect, for example; there are new possibilities for realism and excitement.

As it is, the Kinect launch games show little imagination and seem to be heavily Wii-influenced – and if you compare Kinect with Wii on that basis, you might well conclude that the Wii is better in some ways, worse in others, but cheaper and with better games, and without the friction of Kinect’s somewhat fussy requirements.

Such a comparison is not fair to Kinect, which in concept and hardware is a generation ahead of Wii or PlayStation Move. It now awaits software to take advantage.

The Windows figures are excellent, mostly reflecting Microsoft’s success in delivering a successor to Windows XP that is good enough to drive upgrades.

I’m more impressed though with the Server and tools performance – which I assume is mostly Server – though noting that it now includes Windows Azure. Microsoft does not break out the Azure figures but said that it grew 40% over the previous quarter; not especially impressive given that Azure has not been out long and will have grown from a small base.

The Office figures, also good, include Sharepoint, Exchange and BPOS (Business Productivity Online Suite), which is to become Office 365. Microsoft reported “tripled number of business customers using cloud services.”

Online, essentially the search and advertising business, is poor as ever, though Microsoft says Bing gained market share in the USA. Entertainment and devices grew despite poor sales for Windows Mobile, caught between the decline of the old mobile OS and the launch of Windows Phone 7.

What can we conclude about the health of the company? The simple fact is that despite Apple, Google, and mis-steps in Windows, Mobile, and online, Microsoft is still a powerful money-making machine and performing well in many parts of its business. The company actually does a poor job of communicating its achievements in my experience. For example, the rather dull keynote from TechEd Berlin yesterday.

Of course Microsoft’s business is still largely dependent on an on-premise software model that many of us feel will inevitably decline. Still, my other reflection on these figures is that the cloud permeates Microsoft’s business more than a casual glance reveals.

The “Online” business is mainly Bing and advertising as far as I can tell; and despite CTO Ray Ozzie telling us back in 2005 of the importance of services financed by advertising, that business revolution has not come to pass as he imagined. I assume that Windows Live is no more successful than Online.

What is more important is that we are seeing Server and tools growing Azure and cloud-hosted virtualisation business, and Office growing hosted Exchange and SharePoint business. I’d expect both businesses to continue to grow, as Microsoft finally starts helping both itself and its customers with cloud migration.

That said, since the hosted business is not separated from the on-premise business, and since some is in the hands of partners, it is hard to judge its real significance.

I was not able to attend the press conference for Windows Phone 7 in person but watched the live webcast from New York. I was unconvinced by the phrase “Always delightful, wonderfully mine” which formed the basis of Microsoft CEO Steve Ballmer’s lead-in, but it got better.

Corporate VP Joe Belfiore did a live demo, explained how the team had aimed to simplify the phone and make it where possible seem one step ahead of the user, predicting the information you would want or the next step you wish to take. He also spent some time on enterprise features, especially Office and Exchange integration, which interested me as there is some ambiguity in how Microsoft is positioning the launch devices; consumer is the focus yet business-oriented features keep cropping up.

One of the 5 HTC phones announced today is the HTC 7 Pro which has a keyboard and seems mainly aimed at business users.

Ralph de la Vega from AT&T said that his company will offer Windows Phone 7 from November 8th in USA, initially from LG, but with with 3 devices – LG, HTC, Samsung – available a few weeks later.

Belfiore’s demo looked good, despite a couple of failures from which he made a good recovery. He announced that the much-discussed Copy and Paste feature, which will be absent from the first release, will come as an automatic update early in 2011.

He also spent some time on the Xbox Live integration, which is one feature that is distinctive to Windows Phone 7 and strikes me as a smart move. A couple of XNA games were demoed and look good, one called Ilo and Milo that uses the accelerometer:

and a familiar one from EA, The Sims:

The best part of Microsoft’s launch though was not in the USA but in the UK. Celebrity Stephen Fry, known for his love of all things Apple, got up and and praised the phone.

The BBC’s Rory Cellan-Jones caught some of this on video, and I am going to quote extensively because it touches on something I’ve been tracking for years: Microsoft’s belated recognition of the importance of design:

I made no secret of my dislike of Microsoft over many years. I did think that analogy of a building site, of a Sixties grey office, is essentially what the environments they were making then were. Whatever I may think of this device (and I’m going to come to that in a moment) I think we can all admire the humility which which Microsoft have admitted to the fact that they now, I think, get it. They get the fact that all human beings whether they work in enterprise or in small businesses or are self employed, are human beings first.

You don’t judge the machines you use or the houses you live in or the offices where you work, simply by listing their functions. The first thing you do as a human being, whether you work for a large office or a small one, is say how you feel about it.

…

What I was always excited by when Apple produced things and then when HTC and other OEMs started making fascinating and enjoyable Androids, and even when RIM came out with the Torch, I felt pleasure using them. These are things, we carry them around at all times and our lives flow through and out of them. And the first feeling we should have is one of delight, so when I heard Mr Ballmer use the word “delight” I thought, oh what joy there is in heaven when a sinner repents. Because let’s be frank, Microsoft were grey, they were featureless, they did concentrate so much on enterprise and tickboxes for function, that they forgot that even the greyest number-cruncher in the corporation is a human being first, a father, a husband, a mother, a daughter, whatever, and that their experiences are based on feeling and emotion.

So when they did send me one of these about a week or so ago – I’ve got a few of them, and I’m not being paid – my first feeling was that it was just fun to play with. And I know that’s childish, but isn’t that how you think of cars and many other things we spend our lives doing? That it’s fun to drive. Yes you want it to be economical, yes you want it to get from A to B, yes you want various things.

…

People buy things because they feel that emotional engagement, they feel the pleasure of using it. I have felt enormous pleasure using this phone. Yes, because I’m not a paid spokesman, because I’m not any kind of spokesman for Microsoft, I can say that it has deficiencies; but then that was the thing about the iPhone that everybody felt, people who had Windows Mobile 5, as it then was, they laughed to scorn the iPhone when it arrived because it didn’t have all these functions. But if you remember the tedious horror of drilling down through the menus just to get a wireless connection, on an old WinMob phone, you will understand that it wasn’t about that, people embraced the iPhone because it was simple, it was closed, it was clear.

Now the closed environment is something you’re all going to be speaking about, the ecosystem, you’re all going to be speaking about how it positions itself against RIM and it positions itself, crucially, against the iPhone and the Android, and that’s a decision that only the market and the next year can make.

Some will call me traitor, but I was pleased to stand on stage ad welcome Windows Mobile 7 into the world. Used it for a week. Like it.

This was a great PR coup for Microsoft, but more important, it shows the impact of something I wrote about in 2008: Bill Buxton’s arrival at Microsoft and his work to introduce design-consciousness to Microsoft and its OEMs:

Everybody in that food chain gets it now. Everybody’s motivated to fix it. Thinking about the holistic experience is much easier now than it was two years ago. What you’re going to see with Mobile 7 is going to give evidence of progress.

I thought the launch was good enough to make people want to try this phone; and considering Microsoft’s current position in the market that is a good result for the company.

I’m watching Microsoft’s Steve Ballmer present a session on cloud computing. It’s been underwhelming so far, but I was interested to see how Sky TV will look on Xbox 360 (though I’d readily swap it for BBC iPlayer, which Microsoft seems to be obstructing). The key point: you can watch with your Xbox Live friends and interact during the broadcast.

The broadcast was coming all the way from the UK to west coast USA, which was apparently why the avatars spent some time watching a buffering thermometer. Still, it worked eventually.

A quick glance tells you that Windows suffered a sharp decline, though Microsoft says this is because it has deferred $1.47 billion of Windows 7 upgrade revenue, and that adding this back would reduce the decline to 4% year on year.

Note that even with the deferral, Windows is highly profitable.

The star here is server and tools, growing in the downturn and delivering strongly increased profits. I doubt tools counts for much of this; I’m guessing it reflects the positive reception for Server 2008.

Online is as dismal as ever. Clearly the Live properties are still not performing. Presuming Azure is in this category, it’s possible that this will start to turn this round; that is more likely I guess than an improvement in the fortunes of existing products such as Bing.

Office strikes me as pretty good bearing in mind the weak economy and that Microsoft is now talking about Office 2010. Entertainment and devices ticking along but nothing special.

I’m guessing Windows 7 will deliver Microsoft a great next quarter no matter what; but when if ever will it be profitable online?

Disclaimer: I am not a financial analyst, and hold no shares in companies about which I write. Please do not misconstrue this as investment advice; I know nothing about the subject.